ALERT - FINRA Warns Broker-Dealers

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May 5, 2010

The Financial Industry Regulatory Authority (FINRA), in Regulatory Notice 10-22,  reminds broker-dealers of their obligation to conduct a reasonable investigation of the issuer and the securities they recommend in offerings made pursuant to Regulation D under the Securities Act of 1933 – also known as private placements.

FINRA points out that with more than $600 billion of securities sold in Regulation D offerings in 2008, this important source of capital for many U.S. companies also has led to significant problems in the regulation of broker-dealers participating in private placements.  These problems include fraud and sales practices abuse in providing private placement memoranda that contain inaccurate statements or omit to state information necessary to make informed investment decisions and deficiencies in due diligence.

Both public and nonpublic companies raise capital in private placements.  These securities are not registered with the U.S. Securities and Exchange Commission (SEC) and thus, no federal agency reviews, “clears” or “approves” the private placement or the related offering documents.  It is up to issuers and broker-dealers participating in private placements to assure that accurate and complete information is provided to investors. 

Although Regulation D permits sales of unregistered securities to certain investors without federal registration, the anti-fraud provisions of federal and state law still apply to such offerings.   Anti-fraud provisions under federal securities laws, particularly Section 17(a) of the Securities Act and Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder, contain restrictions against, and penalties for, violations resulting from fraudulent or misleading disclosures, which also can constitute violations of FINRA rules requiring adherence to just and equitable principles of trade and prohibiting manipulative and fraudulent conduct.

The Notice 10-22 reminds broker-dealers that:

  • Reasonable Basis.  A broker-dealer must have reasonable grounds to believe that a recommendation to purchase, sell or exchange a security is suitable for the customer.  To meet this suitability requirement, a broker-dealer must, at a minimum, conduct a reasonable investigation concerning the issuer and its management, the issuer’s business, the assets owned by or to be acquired by the issuer, the claims being made and the use of proceeds of the offering.
  • Suitability for Customer.  The broker-dealer must make reasonable efforts to determine that the investment is suitable for the customer, gathering information about the customer’s other holdings, financial situation and needs, tax status, investment objectives and other information to enable the firm to make a suitability determination.
  • Offering Documents.  A broker-dealer that prepares or participates in the preparation of a private placement memorandum (PPM) or related offering document has a duty to investigate the representations made by the issuer and to determine that it does not contain material misstatements or omissions and that the document is fair and balanced and not misleading.
  • Red Flags.  Broker-dealers must be alert to “red flags” that would alert a prudent person to conduct further inquiry, as would be the case where an issuer fails to adequately explain statements, respond to inquiries and substantiate information that would be deemed material by an investor.
  • Documentation of Reasonable Investigation.  FINRA points out that to demonstrate that it has performed a reasonable investigation, a broker-dealer should retain records documenting the process and results of its investigation.  The scope of a due diligence investigation will vary, depending upon a broker-dealer’s role in the transaction, the nature of the offering and other factors relating to the offering, including whether the offerees are retail customers or institutional investors. A broker-dealer may retain counsel to assist the firm in undertaking and fulfilling its due diligence obligations.

FINRA regularly conducts examinations of private placements sold by broker-dealers.  FINRA sanctions firms that fail to conduct reasonable due diligence examinations of issuers in private placements and where offering documents fail to provide accurate and complete disclosures to investors.  Frequently, firms that fail to conduct reasonable investigations concerning issuers of privately-placed securities also will be charged with advertising violations and supervisory failures.

Briggs and Morgan attorneys regularly advise broker-dealers and issuers in private placement financings and assist in the due diligence investigation process.  We also represent securities brokers-dealers and their associated persons and investment advisors in enforcement proceedings, adversary proceedings, class actions and criminal proceedings.  Please feel free to contact any of our attorneys in the Securities or Financial Markets groups.

For a PDF of this alert, click here.  

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